Credit rating agencies beaten by a spreadsheet

A spreadsheet with some publicly available accounting and market based information can do a better job at predicting the probability that companies will default than the ratings agency Standard and Poor’s, according to a paper released by economists Jens Hilscher and Mungo Wilson, of Brandeis and Oxford Universities.

Olaf Storbeck of Economics Intelligence reports:

At the core of the paper are corporate bond ratings by Standard & Poor’s. Hilscher and Wilson look at all assessments that have been given between 1986 and 2008.

Additionally, they constructed an alternative indicator that is meant to gauge the default risk of the bond issuers. The economists only use publicly available information for this “failure score”, mainly balance sheet data like profitability, leverage and cash holdings.

The authors conclude (pdf):

We find that this measure… is substantially more accurate than rating at predicting failure at horizons of 1 to 10 years.

The higher accuracy in predicting the cumulative failure probability is driven by a much higher ability of failure score at predicting marginal default probabilities at horizons of up to 2 years and the fact that credit rating adds little information to marginal default prediction at horizons up to 5 years.

In other words:

Ratings are in fact a poor predictor of corporate failure.

See also:

• Osborne’s austerity is failing at the one thing it’s supposed to do – Alex Hern, February 14th 2012

• Credit rating agencies weigh in on independent Scotland – Alex Hern, February 6th 2012

• European socialists call for regulation of the ratings agencies – Alex Hern, January 18th 2012

• No, Gideon, low gilt yields aren’t good news, and here’s why – Cormac Hollingsworth, November 16th 2011

• The current crisis: brought to you politician by inaction and unaccountable credit rating agencies – George Irvin, August 8th 2011